August 2019 Volatility
Volatility has been the name of the game in the markets this month. Last week, the Dow Jones Industrial Average suffered an 800-point drop. That was followed by 4 straight days of gains. Friday the index dropped another 600 plus points. The yield on the 10-year US Treasury note has plunged from 2% at the beginning of August and currently sits at 1.53%, a 23.5% drop! There are several factors driving this volatility; the fear of an inverted yield curve, the trade war with China, and the action or inaction of the Federal Reserve Board of Governors.
On Wednesday, August 14th, the Dow dropped 800 points on fears of an oncoming recession. As much of the talk revolved around the inverted yield curve, I thought I might take this opportunity to explain what that signifies and why it matters to market professionals. What is a yield curve? Simply put, it is a graph that plots interest rates paid (yields) versus the time needed to invest to realize those yields. The reason the market indices react violently when yields for shorter term investments (the US 2-Year Treasury Note), have paid more (have a greater yield) than longer term investments (the US 10-Year Treasury Note), is that recessions have typically followed this inversion.
Ten-to-two year yield-curve spreads Notes: The plot in the article below shows the spread between the yields on ten-year and two-year U.S. Treasury securities. The shaded areas denote official periods of recession as identified by the National Bureau of Economic Research.
Why has it been a predictive indicator in the past? The answer lies again in investor’s expectations of the future. If large institutional investors are pouring money into longer term bonds and being paid less interest (yield) than shorter term similar investments (the 2 Year US Treasury Note), then the assumption is that those investors believe that interest rates will continue to fall due to some combination of slowing economic activity and or the Federal Reserve embarking on an interest rate cutting cycle to spur lagging economic growth. In either case, the expectation is that rates in the future will be lower and thus investors are trying to lock in the present rates now, before they fall further.
The trade war with China is also starting to take a toll on the global economy as well as economic sentiment. According to the Factset data quoted above, over a quarter of the S&P companies mentioned tariffs during their earnings call. This is a 40% increase from the amount of companies that mentioned them during their Q1 earnings calls. Further exacerbating the situation, on August 7th, Germany reported that their industrial production fell 1.5% in July and down 5.2% year over year. Six days later, on the 13th, Germany reported that their overall economy contracted 0.1%. The ongoing US trade war with China was again named as the main culprit as the US and China are Germany’s largest and third largest export markets respectively. As Germany is the single engine driving European growth, this news in addition to the inverted yield curve, helped to send the market down 800 points when it was reported.
Where does all of this leave us? I believe we will continue to experience increased daily volatility in the markets due to headline risk. The current administration uses the bully pulpit seemingly on a daily basis (as they did again Friday with regard to China and additional tariffs). Brexit is still a concern. Germany’s economy may be faltering. The trade war with China continues to drag on. The 10 Year US Treasury yield will likely continue to come under pressure as we are the only country in the world with a relatively stable political structure to pay meaningful yields (Germany pays –0.69%, Japan –0.233%, UK 0.452%, Canada 1.153%. Source: Bloomberg Markets).
If we do fall into a recession, remember that recessions are historically short; lasting on average from 6 to 18 months. Review your allocation and risk profiles. Review your financial plan and discuss your concerns with your advisor.
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